One Chart That Shows How Big Of A Disaster The Fed's New Communication Strategy Has Been

The size of the FOMC's regular statement on monetary
policy has ballooned alongside the Fed's balance
sheet.FRB, DB Global Markets
Research

The Federal Reserve's changing communication strategy has been
prone to criticism in the last few years as the central bank
tries to innovate with regard to how it conveys its message to
market participants.

One one hand, Fed officials — including outgoing chairman Ben
Bernanke and incoming chairman Janet Yellen, the latter having
spearheaded much of these efforts during her tenure as vice
chairman — laud the changes they have made, making the case that
the monetary policy decision-making process has become more
transparent.

On the other hand, market participants trying to follow what the
Fed is actually saying these days are having more and more
trouble doing so.

This became really apparent last summer, when Bernanke and others
began signaling that the Fed would possibly seek to begin winding
down ("tapering") its quantitative easing program by the end of
2013.

These communications caused a rise in expected short-term
interest rates as traders pulled forward expectations for when
the Fed would begin tightening monetary policy by hiking its
policy rate.

Fed officials then embarked on a campaign to reassure market
participants that "tapering isn't tightening," sending expected
short rates lower once again.

Now, the Fed has begun tapering as it shifts its reliance toward
market participants' expectations of the future path of
short-term interest rates as its primary tool for providing the
economy with monetary stimulus.

This is known as the Fed's "forward guidance," and its success
relies more than anything else on proper communication of its
future intentions. Current guidance dictates that it will likely
be inappropriate for the central bank to hike its policy rate
until "well past the time that the
unemployment rate declines below 6-1/2 percent, especially if
projected inflation continues to run below the Committee's 2
percent longer-run goal," and current Fed estimates suggest the
rate hike won't come until late in 2015.

Right now, the market is having problems digesting this forward
guidance. Economic data releases tied to the labor market —
especially the monthly jobs report put out by the U.S. Bureau of
Labor Statistics — are causing interest-rate volatility as the
unemployment rate continues to fall closer and closer toward the
Fed's 6.5% threshold (it currently stands at 6.7%).

If the economic data keep improving at the current pace, market
participants will increasingly test the Fed's commitment to
abstain from rate hikes until late 2015 by bidding up
expectations of future short-term interest rates.

This would represent a tightening of monetary conditions, and if
the Fed decides it wants to push back on such a development, it
will have to further modify the language of its policy statement,
perhaps by lowering the unemployment rate threshold — an idea
with problems of its own,
as Michael Feroli, chief U.S. economist at JPMorgan Chase Bank,
points out.

"We believe the Fed will refrain from lowering the
unemployment rate threshold, as it is concerned that such a
change could lead to the conclusion that thresholds can be
adjusted—up as well as down—which would be damaging to the
credibility of those thresholds as commitment devices," says
Feroli.

This is why many market participants believe Janet Yellen's
great experiment with the Fed's communication strategy in recent
years has not been such a big success.

As Ethan Harris, co-head of global economics research at BofA
Merrill Lynch,
put it last summer: "The Fed has taken a step backwards in
terms of communication. By offering so much information in
such a muddled fashion, they have made policy less transparent."